Using Ichimoku Charts In Forex Trading

The technique of Ichimoku Kinko Hyo is relatively recent among traders, but its use is steadily increasing mostly in the forex market , thanks to the ability to generate a higher probability of winning trades. Its diffusion in the forex market follows the already consolidated one of the stock and futures market and owes its success to the synthesis of various indicators able to formulate clear trading strategies and, above all, with a high probability of success. In one chart, we can see 5 indicators capable of generating precise trading signals, under certain conditions.
Let’s see in details how the Ichimoku technique works and how to apply it to a trade.

UNDERSTANDING ICHIMOKU

Before going into details, here is a brief history of this trading methodology. The Ichimoku system was invented by a Japanese journalist, Goichi Hosoda, who spread in 1968 a rather original trading system (Ichimoku Kinko Hyo) compared to those already known. The success that several Japanese traders got using this technique created the conditions for its spread in the world trading room. Although seemingly complicated due to the presence of many lines and indicators in a single graph, this technique can be easily assimilated with the operational practice, making the interpretation of the graph even easier.

Basically, the technique of the Ichimoku cloud is based on the trend of 5 main components and represents a great tool of analysis for a volatile market such as the forex.
The first two indicators that we are going to look at, and that should always be monitored together, are the Tenkan Sen and the Kijun Sen.
Their interpretation and practical application is the same as a classic crossing of moving averages, but they offer a greater filtering of false signals. Let’s see how these two indicators are created:

Tenkan Sen: the sum of high and low, generally concerning the last 9 periods taken into consideration, divided by two; this line is the most reactive one among the indicators of the Ichimoku technique.

Kijun Sen: the sum of the high and low, generally concerning the last 26 periods taken into consideration, divided by two. The method of calculation is therefore the same one as the Tenkan, but, obviously, as it considers a longer period of analysis, it has a greater stability.

What a trader really needs are clear signals to open a position, and what the movement of Tenkan and Kijun Sen offer is very similar to the signal provided by a crossing of moving averages.

Let’s now see a practical example in Figure 1: the daily graph of EURNOK shows a clear cut of the Tenkan Sen (black line ) compared to the Kijun Sen (red line) at point A. This signal provides a first indication to the trader that prices in the short term are trying to reverse a long term downward trend, a signal of a possible bull market in sight.

Figure 1 – Tenkan and Kijun Sen crossover

Another important element of this technique is the Ichimoku “cloud”, together with the great benefit to represent the current and historical trend of prices.
The behavior is typical of a support / resistance and thus serves as an operational limit beyond which the trader can adopt specific behaviors.
The two essential components of the Ichimoku cloud are:

Senkou Span A: the average between Tenkan Sen and Kijun Sen generated by the simple sum of the two indicators divided by two. This average line is shifted forward by 26 periods.

Senkou Span B: the average between the top and low of the previous 52 periods, i.e. the average of the price range of the 52 previous years, moved forward by 26 periods.

The area that is graphically positioned among the Senkou Span A and B is called Kumo (cloud).

One of the main characteristics of the Kumo is the thickness . The greater the thickness, the higher the volatility of the market and therefore also the degree of reliability of any support / resistance offered by the cloud. Here lies the key factor of the Ichimoku technique which takes into account the volatility of the market, something that we cannot not find for example in the classic lines of support and resistance.
The prices crossing of the cloud indicates the probability of a change of trend, especially if the thickness of the Kumo is consistent.
Let’s now see an example of how we can take advantage of this information to open a trade.

We are going to compare the previous graph of EURNOK to the same graph without the Ichimoku cloud (Figure 2). As we can clearly see, in January 2013 EURNOK surpassed the strong resistance of 7.4100, but the subsequent retest of the support would have probably triggered the stop loss for a trader who had entered long simply basing on the classic break of the resistance. Instead, the operation through the technique of the Ichimoku cloud would have been different and quite more reliable, acting as a filter to the possible false signal. The same movement of the previous graph coincides in this case ( point B Figure 3) with the closure of the candle above the cloud and with a top at 7.4350. If we consider the volatility of the market, the crossing of prices through the cloud provides an excellent opportunity for an entry above 7.4350, also providing a first sign of a current trend reversal which is already supported from the previous bullish intersection between the Tenkan and the Kijun Sen.

Figure 2 – Classic resistance break

Figure 3 – Break through the technique of Ichimoku

In this list of indicators we must also quote the Chikou Span. This indicator is composed by the closing values of the temporal chosen time frame, but usually moved back by 26 periods. This indicator is used to get information on the current trend in a certain moment, in practice it is a momentum indicator.
It’s quite simple: if the Chikou (thus the closure of 26 periods ago) is below the current closing prices, then the trend is downward, vice versa if it is placed above. In graph 4 of EURNOK, the Chikou Span is indicated in orange.

Figure 4 – The momentum of the market defined by Chikou

AN OVERALL ANALYSIS

A graph usually expresses the concepts better than words, and so we can put together our considerations and graphically verify what happened to AUDUSD in the spring of 2013.

Figure 5 – A history of trading thanks to the Cloud

TRADING WITH THE ICHIMOKU

The trend of AUDUSD in spring 2013 is a very interesting case to understand and interpret the information that the technique of the Ichimoku cloud provides daily.
AUDUSD was in the trading range between area 1.06 and area 1.01 from August 2012, in a classic distribution phase. The prices were moving sideways preventing the establishment of clear technical signals, whether short or long. What happened in January 2013 is quite interesting, when prices moved under the cloud, anticipated in this movement by the downward cutting of the Tenkan Sen against the Kijun Sen. The experienced trader would not open a trade because the Chikou at that time was still positioned inside the cloud thus making the short signal a false one.
This event signaled a still uncertain trend that in fact was confirmed with a new return of AUDUSD on the top part of the trading range.
Here is in details the strong signal that emerged a few months later.

Figure 6 – The entry signal

At point X AUSDUSD met all the requirements to get a bearish signal, whit the Chikou that 26 times before, was placed in that case under the Cloud. So, after fixing the break price at point X, our trade would have been be activated beneath the low of that session at 1.0224, a preferable strategy compared to the entry generated by the closure below the cloud, as it requires a further confirmation of momentum.
Hence, after setting the entry level a few pips short (let’s say 10) below the low of the session (with the stop above the high of the same one), we would have had to wait for the event.
Our most prudent strategy would have rewarded us, as AUDUSD tried an upward reaction that found an impassable resistance in the cloud, now set downward. After a few sessions of trading, the short signal started, and AUDUSD fell below 1.0214.
This was a successful trade which was confirmed by the subsequent history, but never forget by the money management. In this case the candle that had reported the entry opportunity was not very wide, about 60 pips between top and low, with a preferable risk-reward ratio of at least 2 to 1, which indicated 120 pips ( 1.0094 ) the minimum target of the operation . The target was almost immediately achieved, and it allowed an adjustment of the stop loss in the subsequent sessions, increasing the chances of a good profit.

Concerning the chosen temporal time frame, we can say that the technique of the Ichimoku cloud is valid for rather long time frames (daily , weekly, monthly ), but not for intraday operations, that may be too exposed to the volatility and therefore bearer of false signals.

A SUMMARY

1 ) Tenkan / Kijun : the cutting of the faster line respect the slower one must be interpreted in the same way of a moving average crossing. This element provides a first signal of movement in the trend.
2 ) Confirmation trend with Chikou : the previous signal must be added to the confirmation of the momentum by the Chikou, thus increasing the probability of choosing the right time to accommodate the new trend.
3 ) The closing prices must come out of the cloud: the previous indications are reinforced if they are verified out of the cloud, but the same prices have to close outside them, further increasing the chances of a successful trade .
4 ) Always adopt a money management strategy: this increases the chances of success, but does not exclude the losses. For this reason, the trader must adopt appropriate strategies to control the trade and an appropriate risk-reward ratio for maintaining the capital .

CONCLUSIONS

This technique may scare at the beginning because it seems apparently complex, but in reality, after the acquisition of certain automatisms, every trader, from the beginner to the expert one, can get support from the Ichimoku cloud in its operations. Several indicators are summarized in a chart while also providing adequate filters against false signals. Therefore this technique, not only increases the chances of winning trades, but it is also able to capture the crucial movements of a trend considering its volatility. This last element is very important for traders who want to increase the chances of a profit while minimizing their losses.